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What effect would each of the following events likely have on the level of nominal interest rates?

1. Households dramatically increase their savings rate.

2. Corporations increase their demand for funds following an increase in investment opportunities.

3. The government runs a larger-than-expected budget deficit.

4. There is an increase in expected inflation.

b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%, and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is given by this formula: MRP = 0.02%*(t - 1), where t is the securitys term. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. Assume that Treasury bonds have 0 LP. The default risk premium (DRP), given the companys bond rating, can be determine from the table below. (Remember to subtract the bonds LP from the corporate spread given in the table to arrive at the bonds DRP.)

What yield would you predict for each of these two investments?

rate	Corporate Bond Yield Spread = DRP + LP (%)
U.S. Treasury	0.83
AAA corporate	0.93
AA corporate	1.29
A corporate	1.67

c. Given the following Treasury bond yield information, construct a graph of the yield curve

Maturity	Yield (%)
1 year	5.37
2 years	5.47
3 years	5.65
4 years	5.71
5 years	5.64
10 years	5.75
20 years	6.33
30 years	5.94

d. On the same graph from part (c) construct a new yield curve graph for the A-rated corporate bonds, based on the LP and DRP data for the corporate bond provided in part b.

e. Which part of the yield curve (the left (S-T) side or right (L-T) side) is likely to be most volatile over time? Please explain.

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